On December 15, 2004, the U.S. Securities and Exchange Commission approved a comprehensive final rule (SEC Rule) that sets out the registration, disclosure and reporting requirements for asset-backed securities (ABS) under U.S. securities laws. In 1992, the SEC amended Form S-3 (roughly equivalent to a Canadian shelf prospectus that is available principally to large, seasoned issuers) so that issuers that would not otherwise meet the requirements for using Form S-3 could register offerings of investment grade ABS on this form. Since then, through a series of no-action letters and other rulings, the SEC has further defined how it will administratively apply existing securities laws, which were not drafted with securitization in mind, to ABS. The purpose of the final SEC Rule is to codify and elaborate on the SEC's existing policies regarding ABS, with a view to making them more transparent to market participants. This is the first time that a specific, comprehensive set of rules for the distribution of ABS and ongoing disclosure and reporting requirements for ABS issuers has been compiled in one place.
There is no persuasive argument for the ABS market in Canada to be regulated differently from the ABS market in the United States. We expect, therefore, that Canadian securities regulators will generally harmonize existing Canadian ABS rules with those adopted in the SEC Rule. In addition, to the extent that Canadian receivables or receivables secured by Canadian property may be securitized through the public distribution of ABS in the United States, they will be subject to the rules on foreign ABS set out in the SEC Rule. For these reasons, it is important for Canadian ABS market participants to be aware of the SEC Rule.
This article summarizes aspects of the SEC Rule that we believe would likely be of interest to Canadian ABS market participants.
A. REGISTRATION UNDER THE SECURITIES ACT OF 1933
In the United States, registration statements are filed with the SEC to register offers and sales of securities, whereas in Canada, a prospectus is filed to qualify the distribution of securities. In practice, this distinction is usually not significant. Registration under Form S-1 is equivalent to filing a long form prospectus under Canadian securities laws. Registration under Form S-3 is roughly equivalent to the Canadian short form or shelf prospectus system. A Form S-3 may be filed as a base shelf prospectus whereby each new series of securities is registered under a separate prospectus supplement.
Definition of Asset-Backed Securities
The definition of an asset-backed security determines whether the SEC Rule will apply, regardless of the form of registration statement used. The basic definition of "assetbacked security" under the SEC Rule is
a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to the securityholders; provided that in the case of financial assets that are leases, those assets may convert to cash partially by the cash proceeds from the disposition of the physical property underlying such leases.
The only change from the current definition in Form S-3 is the addition of the proviso relating to leases. The definition in Canada under National Instrument 44-101 is virtually identical to the previous SEC definition—that is, it does not include the additional proviso about leases.
The SEC Rule notes that this definition does not include so-called synthetic securitizations. Under a synthetic securitization, payment is made by reference to an asset not in the pool instead of primarily from the performance of a discrete pool of financial assets that convert to cash.
Under the SEC Rule, the issuing entity must be passive and its activities restricted to the ABS transaction. The SEC Rule notes that in this regard, securities issued by socalled series trusts (or silo trusts, as they are sometimes known) will not qualify as ABS. Under a series trust, the same trust will hold multiple pools of assets and will issue multiple series of securities with recourse in respect of each separate series limited to a specific underlying pool. According to the SEC, this issuer is not "passive" enough to be an ABS issuer. In addition, the SEC was concerned that investors would be forced to analyze any effect on their security, including bankruptcy remoteness issues, if problems were to arise in another wholly separate and unrelated transaction in the same issuing entity—instead of only analyzing the particular pool in question. This is not to be confused with a master trust structure typical in credit card ABS whereby all the securities are backed by separate interests in a single pool. There is no similar restriction in Canada regarding the passivity of an ABS issuer, nor is there any distinction between series trusts and master trusts.
The SEC codified its longstanding staff interpretive position that no non-performing assets may be included as part of the asset pool at the time of the proposed offering. The issue is that such non-performing assets are not converting into cash within a finite time period and that management or other action may be needed to convert them to cash. Any securities backed by nonperforming assets will not qualify as ABS. An asset will be defined as "non-performing" if it meets the charge-off policy set out in the transaction documents or the chargeoff policy of the sponsor or any charge-off policies established by the primary regulator of the sponsor. If the transaction specifies a cut-off date, then the time for calculating the non-performing thresholds is on that date. In the case of master trusts, the date for calculation is the date as of which delinquency and loss information is presented in the prospectus for the securities.
Similarly, limits are put on the total amount of delinquent assets that may be contained in a pool at the time the ABS are issued. An asset will be defined as "delinquent" if any portion of a contractually required payment on the asset iS-30 days or more past due. For Form S-3 eligibility, delinquent assets may not constitute 20% or more, by dollar value, of the original asset pool. For offerings to be registered on Form S-1, delinquent assets may not constitute 50% or more, by dollar value, of the original asset pool. However, if a security is backed by assets that include non-performing or defaulted assets, and that security does not give credit to those assets, then they need not be considered as part of the asset pool for determining non-performing and delinquency thresholds. In addition, any assets that would not be considered delinquent under the recognition policies of the sponsor or servicer of that pool need not be considered as part of the asset pool for determining delinquent thresholds. When these thresholds are applied against a master trust structure, they are to be measured against the entire pool whose cash flows support the securities and not just against any new assets that are added as a result of the new issuance. No Canadian securities regulator has yet taken the position that limitations must be placed on defaulted or delinquent assets for securities to qualify as ABS.
The SEC believes that the definition of asset-backed security requires the additional proviso regarding leasebacked securitizations because lease-backed securities are not backed solely by financial assets that "by their terms convert into cash." They also involve the liquidation of physical assets to obtain cash. The SEC Rule imposes limits on the portion of anticipated cash flow that is to come from residual values. For motor vehicle leases, this portion of the cash flow may not constitute 65% or more of the original asset pool, and for all other leases, 50% or more of the original asset pool. In addition, for Form S-3 eligibility for leases other than motor vehicle leases, the portion of the cash flow anticipated to come from residual values may not constitute 20% or more of the original asset pool. The SEC Rule also requires additional disclosure regarding the way the residual value was calculated. No Canadian securities regulator has yet proposed similar limitations.
The requirement in the definition of asset-backed security that the asset pool be "discrete" is to prevent a level of portfolio management that is not consistent with the passive nature of ABS; however, the phrase "fixed or revolving" was added to make it clear that the definition covers revolving credit arrangements, such as credit card and short-term trade receivables, under which account or loan balances revolve as a result of periodic payments, charge-offs and closings of the receivables. The basic principle is that the balance of a pool asset may revolve, but not the asset pool itself. SEC staff has allowed three limited exceptions relating to master trusts, prefunding periods and revolving periods.
The SEC Rule will allow master trust structures to meet the definition of asset-backed security without any predetermined limits. This means that additional pool assets may be added without limit, so long as they are consistent with the existing asset pool and that they are added in contemplation of future issuances or in connection with maintaining minimum pool balances.
For prefunding periods, the SEC Rule stipulates that a prefunding period is permitted for up to one year from the date of issuance of the asset-backed securities and that the prefunded amount may consist of up to 50% of offering proceeds or, in the case of master trusts, up to 50% of the aggregate principal balance of the total asset pool whose cash flows support the asset-backed securities.
The SEC Rule sets no limit on the number of assets that may revolve, nor on the duration of the revolving period for receivables or other financial assets that by their nature revolve (e.g., credit cards, dealer floor plan financings or home equity lines of credit). For fixed receivables or other financial assets (e.g., standard residential mortgages, auto loans and leases), an unlimited revolving period will be permitted for up to three years, so long as the new pool assets that are added are of the same general character as the original pool assets.
So far, no Canadian securities regulator has taken a position imposing restrictions on prefunding or revolving periods for securities to qualify as ABS.
The SEC Rule provides that ABS offerings will be registered on Forms S-1 (the equivalent of a long form prospectus) or S-3 (roughly the equivalent of a short form or shelf prospectus), as applicable. The SEC Rule sets out which parts of the current forms are required, if applicable to the transaction, and which parts may be omitted. It specifies a requirement for Form S-3 offerings to prepare separate base prospectuses and forms of prospectus supplements when multiple asset types may be securitized or if there is any difference in country of origin of the receivables or of property securing the receivables, which will also require a separate base prospectus and form of prospectus supplement for each country. However, for both the above requirements, the SEC Rule clarifies that a separate base and form of supplement only is required for asset types or jurisdictions that may be securitized in a discrete pool in separate takedowns under the registration statement. If pool assets of different asset types or different jurisdictions are to be pooled together in a single transaction, a single base and form of prospectus supplement will be permitted, so long as the appropriate disclosures for each asset type or jurisdiction is included. In addition, a single base and form of supplement is permitted when the additional class of assets, or assets located in separate jurisdictions, are limited to 10% of the pool for any particular takedown. Currently, in Canada under National Instrument 44-102, one base shelf prospectus may be used for several asset types offered through separate prospectus supplements.
In the United States, securitization transactions are often done in two steps. First, the financial assets are transferred by the holder of the financial assets (referred to as the "sponsor") to an intermediate entity (referred to as a "depositor", which is often a limited purpose entity created by the sponsor), and then the depositor transfers the assets to an issuing entity for the particular ABS transaction. The SEC Rule stipulates that for continued Form S-3 eligibility for new transactions, the reporting obligations regarding other ABS transactions involving the same asset class established by the depositor or an affiliate of the depositor (and any issuing entity established by those organizations) must have been complied with for the previous 12 months. An exception is provided for an affiliated depositor that became an affiliate as a result of a merger or acquisition during the 12-month period before the filing of the registration statement. In these circumstances, the filing of any material, prior to the merger or acquisition, relating to ABS of a previously established issuing entity by such affiliated depositor is excluded, provided such merger or acquisition was not part of a plan or scheme to evade the requirements of the Securities Act of 1933 (Securities Act) or the Securities Exchange Act of 1934 (Exchange Act).
The SEC Rule clarifies that the depositor for the ABS, acting solely in its capacity as depositor to the issuing entity, is the "issuer" for purposes of the ABS of that issuing entity. Where there is no depositor separate from the sponsor, the sponsor will be the "issuer". This means that the registration statement will usually have to be signed by the depositor, the depositor's principal executive officer and principal financial officer and by at least a majority of the depositor's board of directors or persons performing similar functions. Furthermore, the SEC Rule specifies that the person acting in its capacity as depositor for the issuing entity of an asset-backed security is a different "issuer" from that same person acting as a depositor for any other issuing entity or for purposes of that person's own securities. In Canada, the sponsor or depositor may be a promoter, but is not deemed to be the issuer. It is interesting to contemplate the impact on the structure of Canadian securitization transactions if Canadian regulators move to the U.S. model. Without a two-step transaction with a separate sponsor and depositor, it would be the officers and directors of the sponsor who would have to sign the prospectus on behalf of the issuer. The adoption of this requirement could lead to more widespread use of separate special purpose depositors in two-step transactions in Canada.
Until the final SEC Rule, offerings of foreign ABS could be effected only through a Form S-1 registration statement. Under the SEC Rule, a Form S-3 registration statement may be used for investment grade ABS backed by or representing interests in foreign assets, provided that enhanced disclosure is required. If ABS are issued by a foreign issuer, are backed by foreign assets, or make use of credit enhancement or other support provided by a foreign entity, then the disclosure document must also describe any pertinent governmental, legal, regulatory or administrative matters and any pertinent tax matters, exchange controls, currency restrictions or other economic, fiscal, monetary or potential factors that could materially affect payment or performance of the assets contained in the pool. Regulation AB contains a specific disclosure item for issuers of foreign ABS that refers to Instruction 2 to item 202 of Regulation S-K (dealing with any foreign-law limits on voting, dividends or interest, and requires an outline of taxes to which U.S. securityholders may be subject) and that refers to the information required by item 101(g) of Regulation S-K (requiring a description of the enforceability of civil liabilities against foreign persons). Disclosure in registration statements for foreign ABS issuers must "clearly articulate the material differences and effects of the home country legal and regulatory regime." Therefore, it is not sufficient to merely describe the home country's legal and regulatory regime; it is also necessary to compare these regimes with the U.S. legal and regulatory regime. This will require a cooperative effort by legal counsel on both sides of the border. The SEC states in the SEC Rule that it encourages prefiling conferences with the staff, where appropriate, to discuss the home country's legal and regulatory environment, the proposed transaction and the relevant disclosure that will be required. The SEC suggests that registrants should consider building additional time into their planning schedules for a possible staff review of the disclosure.
In Canada, Form 44-101F3 includes one item (item 8.3) that specifies additional disclosure applicable for distributions of ABS. This information generally pertains to the nature, performance and servicing of the underlying pool of financial assets, the structure of the securities and dedicated cash flows and any third-party or internal support arrangements established to protect the holder of the ABS from losses associated with non-performance of the financial assets or disruptions in payment. Any single person who sold or deposited over 33% of the dollar value of the financial assets composing the pool must be described, although there are no requirements regarding the provision of specific financial information of this person.
The SEC Rule sets out disclosure items tailored for ABS prospectuses in a new Regulation AB. This disclosure specifies requirements for Securities Act registration statements as well as disclosure required in distribution reports to be filed on an ongoing basis on Form 10-D (described below), the form of compliance report to be required from the depositor or servicer and the contents of a required filing from a registered public accounting firm's attestation report on the assessment by the depositor or servicer.
Although very few of the required disclosure items described below are mandated under Canadian securities laws, their inclusion in U.S. registration statements may constitute evidence of their materiality for Canadian disclosure purposes.
Description of Transaction Parties
In addition to containing basic identifying information about the sponsor, a registration statement must describe the sponsor's securitization program and detail the sponsor's experience and overall procedures for originating or acquiring and securitizing assets of the type to be included in the specific transaction. Such information would include, to the extent material, the size, composition and growth of the sponsor's portfolio of assets of the type to be securitized. Moreover, information or factors related to the sponsor that may be materially relevant to an analysis of the origination or performance of the pool assets, such as whether any prior securitizations organized by the sponsor have defaulted or experienced an earlier amortization or other performance triggering event, must also be described. Other required information would include the sponsor's credit-granting or underwriting criteria for the asset type being securitized and the extent of the sponsor's outsourcing of its origination or purchasing functions, as well as the extent to which the sponsor relies on securitization as a funding source. In addition, a description of the sponsor's material roles and responsibilities in its securitization program and the sponsor's participation in structuring the transaction is mandated, including whether the sponsor or an affiliate is responsible for the selection of the pool assets.
The registration statement must disclose the ownership structure and general character of the activities of the depositor. In addition, if material and materially different from the sponsor's program, information regarding the depositor's securitization program and its experience would be required. Finally, disclosure is required regarding any continuing duty of the depositor after issuance of the ABS with respect to the ABS or the pool assets.
(iii) Issuing Entity
The governing documents of the issuing entity and any applicable management or administrative agreement must be filed as exhibits to the registration statement. The registration statement must also set out information regarding permissible activities, restrictions on activities and capitalization of the issuing entity. If the issuing entity has executive officers or directors, the proposed SEC Rule expands existing practice by requiring information under item 401 of Regulation S-K (identification of and information regarding these persons), item 402 (compensation information), item 403 (information about ownership of registrant's securities) and item 404 (information about affiliated transactions). In addition, the registration statement must indicate whether any security interests granted are perfected, maintained and enforced; whether or not the issuing entity can declare bankruptcy; and in the event of its bankruptcy, whether its assets could become part of the bankruptcy estate or subject to the bankruptcy control of a third party. Part 12 of National Instrument 51-102 now requires that Canadian issuers file copies of their constating documents and by-laws, as well as all other material contracts to which the issuer is a party.
Often the servicer of the asset pool is the sponsor, but this is not always the case. The SEC Rule defines "servicer" as any person responsible for managing or collecting the pool assets or making allocations or distributions to holders of ABS. There is often more than one servicer. The registration statement would have to identify the master servicer (a term that is not defined in the SEC Rule), each affiliated servicer, each unaffiliated servicer that services 10% or more of the pool assets, and any other servicer, such as a special servicer, that performs workouts, foreclosures or other material aspects of the servicing of the pool assets (collectively, "Material Servicers").
Except for unaffiliated servicers that service less than 20% of the pool assets, each Material Servicer must provide additional disclosure such as the general character of its business, the size, composition and growth of its portfolio and how long it has been servicing assets. In addition, information must be disclosed for each Material Servicer regarding any other securitization transactions that have defaulted or experienced early amortizations or any material non-compliance with servicing criteria in addition to any material changes to servicing policies or procedures in the past three years. Moreover, information regarding the financial condition of each specified Material Servicer would be required if it could materially affect any aspect of servicing the pool assets that could, in turn, materially affect pool performance.
The registration statement must also set out the terms of any servicing agreement (and any subservicer agreement) and each such agreement would have to be filed as an exhibit.
Backup servicing or other servicer transition arrangements must also be described. Information must be provided regarding the terms of removal, replacement, resignation or transfer of the servicing function and the process for transferring servicing from one servicer to another.
An ABS transaction may involve one or more trustees. For example, there may be separate trustees for the issuing entity and for the ABS indenture. The registration statement would have to describe each trustee's duties and responsibilities under the governing documents and under applicable law, disclose the trustee's prior experience in similar ABS transactions and any provisions relating to indemnification, limitations on liability and removal or replacement of the trustee. There would also have to be disclosure regarding the extent to which any trustee independently verified calculations, monitored compliance with covenants or could take any action, including any requirement to provide notice to investors. In addition, disclosure must be made regarding the required percentage of any class of ABS needed to require the trustee to take any action.
(vi) Significant Originators
The SEC Rule requires disclosure regarding the identity of any non-affiliated originator, other than the sponsor, that has originated or expects to originate 10% or more of the pool assets. Additional disclosure must be made regarding any originator that originates 20% or more of the pool assets. This additional disclosure includes information regarding its origination program, the size and composition of its origination portfolio and its creditgranting and underwriting criteria.
Disclosure Regarding Pool Assets
(i) Pool Composition
The registration statement would have to provide the following information on the composition of the asset pool:
- asset type and material terms of the pool assets;
- solicitation, credit-granting or underwriting criteria;
- selection criteria and cut-off date;
- the effect of legal or regulatory provisions such as bankruptcy, consumer protection and privacy laws;
- statistical information, and the methodology used, for the particular type of asset class;
- if 10% or more of the pool assets are located in any one state or geographic region, information regarding economic or other factors specific to that state or region that may materially affect the pool assets or cash flows;
- delinquency and loss information (delinquencies are to be presented in 30 or 31-day increments through the point of charge-off both by number of accounts and by dollar amount); and
- the way delinquencies and charge-offs are defined, describing grace periods, re-aging and restructuring practices.
The most novel additional requirement in the SEC Rule is the inclusion of static pool data. These types of data indicate performance over time of groups, or static pools, of assets such as those originated at different intervals. It is believed that the presentation of static pool data will permit investors to detect patterns that may not be evident from overall portfolio numbers. The SEC states that static pool data are often available to sponsors and provided to rating agencies. The SEC is now requiring that such data be included in the registration statement if the data would be material to the reasonable investor. In particular, it is proposed that five years of static pool data for the sponsor's overall portfolio (or for such shorter period as the sponsor has been making originations or purchases) be included and that such data be presented in increments (e.g., monthly or quarterly) material to the asset type being securitized. The starting point for disclosure is, to the extent material, static pool information regarding delinquencies, cumulative losses and prepayments, as applicable for the asset type, for the sponsor's overall portfolio. In addition, for amortizing asset pools, selected material characteristics for the prior securitized pools or any vintage origination years should also be provided. For revolving asset master trusts, the starting point for static pool disclosure is data, to the extent material, regarding delinquencies, cumulative losses, prepayments, payment yield, yield and standardized credit scores or other applicable matters of obligor credit quality, as applicable, in separate increments based on the date of origination of the pool assets. Moreover, the SEC clarifies that if any information that would otherwise be required as static pool data is not material, but alternative static pool information exists that would provide material disclosure, such alternative information is to be provided instead. Although this issue is not dealt with in the SEC Rule, one may expect the inclusion of such data to lead underwriters to require auditor's comfort on such data, and this could increase the expense of transactions or delay them. Given concerns about proper due diligence on static pool data for periods prior to January 1, 2006, the SEC Rule specifies that such information will be deemed not to be part of any prospectus for an ABS offering.
The SEC Rule also provides several methods whereby static pool data may be disclosed. First, the issuer may include the information in the prospectus or incorporate it by reference from a filed Exchange Act report. Alternatively, issuers may post static pool data on their website if certain conditions are met. Any information permitted to be posted on a website would be deemed to be included in the prospectus.
For CMBS transactions, given the importance of the underlying properties, there is an additional list of disclosure items similar to disclosure required for the registration of offerings of securities for certain real estate companies.
(ii) Sources of Pool Cash Flow
Where an ABS transaction has cash flows from different sources, such as in lease-backed transactions that include separate cash flows from lease payments and the sale of residual assets at termination of the lease, disclosure must be made regarding the specific sources of funds and their uses, including, if applicable, the relative amount and percentage of funds that are to be derived from each source and a description of any assumptions, data, models and methodology used to derive such amount. Disclosure regarding cash flows from residual values must also include information regarding the manner and process in which residual values are to be realized, including disclosure of the entity that will convert the residual values into cash and that entity's experience.
(iii) Changes to Composition of Asset Pool
Where an asset pool may change, such as through a prefunding or revolving period, additional disclosure will be required regarding the term or duration of such prefunding or revolving period; the aggregate amounts or percentages involved; triggers that will terminate such periods; the manner in which new pool assets may be added, removed or substituted; any minimum requirements to add or remove pool assets; temporary investment of funds pending use; and whether investors will be notified of any changes to the asset pool and the manner in which that notification will take place.
(iv) Rights and Claims Regarding the Pool Assets
Disclosure must include any rights that the investors may have against the sponsor and depositor regarding the pool assets, such as for breaches of representations and warranties in the transaction agreements and any material claims that parties other than the asset-backed securityholders may have on the asset pool.
In Canada, item 8.3 of Form 44-101F3 provides general disclosure requirements regarding pool composition, performance and risk factors; specific guidance as set out in Regulation AB is not provided.
Transaction Structure Disclosure
The registration statement must include a clear description of the flow of funds, presented in both narrative and graphic form. A separate table providing an itemized list of all estimated fees and expenses payable out of the transaction cash flow is also required. Other required information regarding the transaction structure includes the following:
- frequency of distribution and arrangements for cash held;
- ownership of residual or retained interest; however, the identity of the residual holder must be disclosed only if the residual holder is an affiliated party or if the residual holder has rights that may alter the transaction structure beyond receipt of residual or excess cash flows;
- any requirements to maintain a minimum amount of excess cash flow or spread;
- additional information if the transaction involves a master trust, including terms under which additional series or classes may be issued and pool assets increased or changed, the relative priority of those additional securities to the securities being offered and their respective rights to the underlying pool assets and cash flows, allocations of cash flow from the asset pool and any expenses/losses among the various series or classes;
- prepayment, maturity and yield considerations, including material models used to identify cash flow patterns, and tables providing sensitivity to changes in the rate of payment; and
- the word "callable" to be included for any redemption or termination feature that may be exercised when 25% or more of the original principal balance of the pool is still outstanding.
Disclosure on Significant Obligors
An obligor and its affiliates that owe 10% or more of the receivables composing the asset pool, or a single property or group of related properties securing a receivable or group of receivables if such receivables represent 10% or more of the asset pool, are considered "significant obligors". Both descriptive and financial information is required. Descriptive information includes the identity of the significant obligor, its organizational form, the general character of its business, the nature of the concentration and the material terms of the pool assets or the agreements with the obligor involving the pool assets. Different levels of financial information are required depending upon the level of concentration. If pool assets relating to a significant obligor represent 10% or more but less than 20% of the pool assets, the ABS registration statement must provide selected financial data respecting the significant obligor for five years under item 301 of Regulation S-K. The selected financial data include items such as net sales or operating revenues, income or loss from continuing operations per share, total assets, longterm obligations and cash dividends. If the pool assets relating to a significant obligor represent 20% or more of the asset pool, full audited financial statements of the significant obligor are required. Canadian rules contain no comparable express disclosure requirement
Credit Enhancement and Other Support
The registration statement must describe the methods and mechanics of both internal credit enhancement structured into the transaction, such as overcollateralization, and external credit enhancement, which is defined to include any mechanism to ensure that payments are timely, such as liquidity facilities; any form of credit enhancement designed to ensure that the securities or assets will pay in accordance with their terms, such as letters of credit; and any derivatives whose primary purpose is to provide credit enhancement to the related pool assets or the securities. If any entity or group of affiliated entities providing enhancement or other support for the ABS is liable or contingently liable to provide payments representing 10% or more of the cash flow supporting any offered class of ABS, both descriptive and financial information will be required regarding such entity. As with significant obligors, where the liability may represent 10% or more but less than 20% of the cash flow, selected financial data required by item 301 of Regulation S-K must be provided. If the support may constitute 20% or more of the cash flow, full audited financial statements will be required. In Canada, item 8.3 of Form 44-101F3 requires specific disclosure of persons providing credit enhancement or support, as well as the general business activities and material responsibilities of such persons, but it does not require disclosure of specific financial information.
The SEC Rule has created a separate disclosure item for derivatives, such as interest rate and currency swaps, that are used to alter the payment characteristic of the cash flow from the issuing entity and whose primary purpose is not to provide credit enhancement. For all such instruments, basic information about the derivative counterparty is required, including the name, its organizational form and the general character of its business. Disclosure of the material terms of the instrument is required and the agreement itself must be filed as an exhibit. In determining whether additional financial information is required for these derivative instruments, the SEC Rule provides that the measurement of the significance of the derivative must be based on a reasonable good faith estimate of the maximum probable exposure, made in substantially the same manner as that used in the sponsor's internal risk management process in respect of similar transactions. The resulting estimate must be measured against the aggregate principal balance of the pool assets. Like other forms of credit enhancement set out above, additional financial disclosure concerning the derivative counterparty is required at a 10% threshold followed by more significant disclosure at the 20% threshold. No similar disclosure of derivative counterparties is required in Canada.
Affiliates and Certain Relationships and Related Transactions
The registration statement is required to describe whether, and if so, how, the sponsor, depositor or issuing entity is an affiliate of any of the following parties: material servicer, significant obligor, significant enhancement provider, originator of at least 20% of the pool assets or other material party identified with the transaction. Disclosure must also be made of any business relationships among such parties outside the ordinary course of business or on non-arm's-length terms where such disclosure is material to an investor's understanding of the ABS transaction. In Canada, item 8.3 of Form 44-101F3 requires similar disclosure for originators, trustees, servicers and credit supporters. In addition, under the SEC Rule any specific material relationships involving or relating to the current ABS transaction and pool assets must be described, even if the relationship is in the ordinary course of business and on arm's-length terms. For example, the existence of credit arrangements such as warehouse facilities relating to pool assets provided by the underwriters or a promoter must be described. In Canada, National Instrument 33-105, Underwriting Conflicts, does not provide specific guidelines for ABS issuers.
Third-Party Financial Information
Under certain conditions, required financial information regarding third-party significant originators, significant obligors or significant credit enhancement providers can be incorporated by reference to publicly filed financial information. For certain unrelated significant obligors, the obligation to include certain financial information may be satisfied by referring to publicly filed reports without incorporating them by reference. Where financial information of a significant obligor is provided by reference to public information and that obligor suspends its public reporting, issuers have the option of structuring their securities to provide for the termination of the transaction as it relates to the assets supplied from such obligor (either by distributing such assets in specie to investors or by liquidating such assets), rather than having to continue to provide financial information where it becomes impractical to do so. In Canada, other than the general ability of issuers to incorporate information by reference in a short form prospectus, there is no comparable provision in Canadian securities laws to specifically authorize incorporation of third-party financial information.
C. COMMUNICATIONS DURING THE OFFERING PROCESS
ABS Informational and Computational Material
In Canada, during the marketing period, an issuer may not use information that is not included, or that cannot be derived from information, in a preliminary prospectus. This restriction does not work well in a shelf prospectus system, where a prospectus supplement need not be prefiled (except where the securities to be distributed are "novel" within the meaning of National Instrument 44- 102). In the United States, section 10 of the Securities Act has similar restrictions to those in Canada. However, in the 1990s, following a series of staff no-action letters, ABS issuers were permitted to use term sheets and computational material before the availability and delivery of the final prospectus or prospectus supplement, subject to various filing requirements that depend on the type of material. No similar relief exists in Canada where (i) marketing certain ABS requires providing informational and computational material, and (ii) the preliminary short form prospectus is the source for computational material. For these reasons, in practice, short form prospectuses are the predominant method of distribution rather than the shelf system with prospectus supplements.
The SEC Rule will codify the concept in the SEC staff noaction letters that permit the use of ABS informational and computational material after the effective date of the registration statement for an offering of ABS registered on Form S-3 but before delivery of the final prospectus. The exemption will be available only with respect to registered offerings of investment grade ABS that meet the Form S-3 requirements. The SEC Rule provides a definition of "ABS informational and computational material" that is limited to specific types of information. The SEC has also included several non-exclusive examples of information to clarify the scope of information that may be provided. Static pool data and statistical information such as interest rate, loss and prepayment sensitivity analysis will be permitted, as will data at individual pool asset or loan levels. In most cases, where an investor analytics or other third-party service provider is used to permit investors to perform their own calculations, only the inputs, models and other information provided by the issuer or underwriter will constitute ABS informational and computational material; however, if the issuer or underwriter is affiliated with the service provider, the resulting analysis may be treated as ABS informational and computational material.
The SEC Rule stipulates conditions for use of ABS informational and computational material. The following ABS informational and computational material must be filed with the SEC: (i) if a prospective purchaser has indicated that it will purchase all or a portion of the class of ABS to which such materials relate, all materials relating to such class that are or have been provided to such prospective investor; and (ii) for any other prospective investor, all materials provided to that prospective investor after the final terms have been established for all classes of the offering. There is certain required cover-page disclosure. The material will be considered part of a prospectus and will therefore attract prospectus liability. Disclaimers of responsibility for misinformation in such material would be inappropriate. The material as filed will be incorporated by reference into the Form S-3 registration statement.
On October 26, 2004, the SEC proposed significant modifications to the securities registration and offering processes (Offering Process Release). If the Offering Process Release is adopted as proposed, there would be a significant expansion in the definition of ABS informational and computational material, and it would change the liability rules affecting these materials because they would become free-writing prospectuses. A detailed description of the Offering Process Release is beyond the scope of this paper.
The SEC Rule codifies an existing safe harbour with respect to research reports as they relate to ABS offerings registered on Form S-3. Canada has no similar rules regarding the publication of research reports around the time of an offering.
D. ONGOING REPORTING AND CONTINUOUS DISCLOSURE
While ABS are subject to Exchange Act reporting obligations, the SEC has recognized that the disclosure required under this Act is generally not relevant for ABS. The SEC has issued several exemptive orders and no-action letters permitting ABS issuers to modify the reports they may file to fulfil their Exchange Act reporting obligations. After many years of issuing no-action letters, SEC staff ceased requiring each new registrant to obtain a new no-action letter and is instead instructing new ABS issuers to look to an existing no-action letter granted with respect to another issue that has substantially similar characteristics as the new ABS. The SEC Rule will codify the existing modified reporting system for ABS. In Canada, ABS issuers still regularly seek rulings to modify their continuous disclosure obligations under securities laws.
Determining the "Issuer"
Consistent with the requirements for registration statements, the "issuer" will be deemed to be the depositor acting in that capacity (or the sponsor where there is no separate depositor). The depositor will be required to sign the Exchange Act reports, although an authorized representative of the servicer would also be entitled to sign on behalf of the issuing entity. Issuers may not combine reporting of multiple transactions into a single report. The SEC Rule creates a separate reporting obligation for ABS transactions if the issuing entity holds a pool asset that represents an interest in, or the right to payments or cash flows of, another asset pool, such as an issuance trust structure. Since these structures are designed solely to facilitate the structuring of the transaction, separate reports regarding the intermediate financial asset will not be required if certain conditions are met.
In Canada, regulators continue to follow a more formal approach. If the issuer is a corporation, the appropriate officers of that corporation must sign the continuous disclosure reports. If the issuer is a trust, either the trustee of the trust or the appropriate officers of an administrator of the trust appointed by the trustee must sign the continuous disclosure reports. Servicers of assets who are not also the administrators of the issuer have no authority to sign reports. Furthermore, entities fulfilling the role of "depositor" in a Canadian ABS transaction are not obligated to make any continuous disclosure reports.
Form of Reports
Currently, ABS issuers in the United States are generally not required to file annual and quarterly financial statements. Instead, they are permitted to file monthly distribution statements required by the ABS transaction documents. The SEC Rule provides for a new Form 10-D to act as the report for periodic distribution and pool performance information for ABS issuers. The Form 10-D must be signed by the depositor or, alternatively, by a duly authorized representative of the servicer on behalf of the issuing entity. If multiple servicers are involved, the Form 10-D may only be signed by a representative of the master servicer.
In Canada, only certain ABS issuers have obtained rulings permitting them to file monthly distribution reports in lieu of financial statements. Several ABS issuers in Canada therefore still file relatively meaningless financial statements while posting distribution reports on the servicer's website as part of its contractual obligations. There is currently no regulatory requirement in Canada for anyone to certify the monthly distribution report for securities law purposes, even though this is the disclosure statement that most investors rely on for ABS.
The SEC Rule specifies the information that is to be contained in or attached as an exhibit to Form 10-D. Although the regulation governing disclosure sets out a number of items that must be disclosed, with nonexclusive examples of the types of information required, issuers are required to tailor their actual disclosure to the asset pool and transaction involved. Canada has no regulations, rules or even exemptive orders that attempt to mandate what must or should be contained in periodic reports filed in lieu of quarterly or annual financial statements. The rights of ABS investors to periodic pool asset performance disclosure are governed entirely by the governing transaction agreements.
Annual Reports and Certification Requirements
A separate general instruction for Form 10-K (the annual report form for most U.S. domestic issuers) will specify how that form is to be used for ABS issuers. The Form 10-K is to be signed either on behalf of the depositor by the senior officer in charge of securitization or on behalf of the issuing entity by a senior officer in charge of the servicing function of the servicer. Updated financial information regarding significant obligors and enhancement providers will also be required, although, subject to certain conditions, these may be provided through incorporation by reference or by including a reference to their SEC filings. Audited financial statements of the ABS issuer are not required; nor are there any requirements regarding internal control over financial reporting. In Canada, there are no similar exemptions regarding audited financial statements and internal control over financial reporting for Canadian ABS issuers.
The Form 10-K will require as an exhibit a "servicer compliance statement"—that is, a statement signed by an authorized officer of the servicer to the effect that the activities of the servicer and its performance under the servicing agreement have been reviewed under the officer's supervision and that to the best of the officer's knowledge and except as otherwise disclosed, the servicer has fulfilled its obligations under its servicing agreement in all material respects throughout the reporting period. If subservicers were involved in servicing the pool assets, a separate compliance statement will be required from each affiliated servicer and each unaffiliated servicer that services 10% or more of the pool assets.
Certification Under Section 302 of the Sarbanes-Oxley Act of 2002
The SEC Rule provides for a separate form of certification under the Sarbanes-Oxley Act of 2002 (S-Ox) for ABS issuers. This certification refers to the information provided in the new Form 10-D and refers to the servicer's fulfilling its servicer obligations. There will be a different form of certificate depending on whether it is signed by the senior officer in charge of securitization of the depositor or by the senior officer in charge of the servicing function of the servicer. This certification must be signed by the same person who signed the related Form 10-K.
In Canada, Multilateral Instrument 52-109 mandates a form of certification similar to section 302 of S-Ox. The form does not specify who should sign on behalf of an ABS issuer, nor does it take into account differences between ABS issuers and corporate issuers, or contemplate a modified certificate where regulatory relief has been obtained from the requirement to file financial statements. Currently, exemption from the MI52-109 certification requirements requires each issuer to obtain specific exemptive relief, although the Canadian securities regulators are currently contemplating approving a form of certification for ABS issuers.
Report of Compliance with Servicing Criteria and Accountant’s Attestation
The SEC Rule enhances the SEC's current framework for reporting on compliance with servicing criteria. The annual report on Form 10-K must include as exhibits reports from each party participating in the servicing function that assesses compliance with the servicing criteria being adopted in Regulation AB. The person who signs the S-Ox Certificate is required to certify that assertions prepared by all parties participating in the servicing functions (as specified below), and associated attestation reports from registered public accountants, have been included as exhibits to the report on Form 10-K, except as otherwise disclosed. In addition, the certifying person must certify that all material instances of noncompliance with the servicing criteria described in the reports have been disclosed on the 10-K report. For the person to make this certification, reports will have to be accumulated from all parties participating in the servicing function, along with associated attestation reports. Reports on assessments of compliance with servicing criteria will be required by any party participating in the servicing function unless that party's activities relate only to 5% or less of the pool assets.
The SEC will allow an assessment of a given servicer's compliance with servicing criteria in respect of the "platform" through which it carries out its servicing for all transactions involving a particular asset class. The assessment need not be on a transaction-by-transaction basis. Where there are subservicers, the responsible party will still be required to assess material compliance with all servicing criteria. For this purpose, the responsible party will be permitted to reasonably rely on information provided to it by unaffiliated parties.
The SEC Rule adopts a uniform set of servicing criteria based on the servicing criteria set out in the Uniform Single Attestation Program for Mortgage Brokers (USAP), developed by the Mortgage Brokers Association (last revised in 1995). The new servicing criteria extend beyond USAP in several areas. These criteria propose certain specific time frames adapted from the current USAP; however, the SEC Rule permits the transaction agreements to provide alternative time frames that would govern. The criteria consist of four broad categories:
- General servicing considerations: whether the servicer or other relevant party has instituted policies and procedures for structural monitoring of ABS (e.g., events of default) and performed other general administrative tasks;
- Cash collection and administration: whether the servicer or other relevant party has administered the collection of cash from obligors, segregated (as applicable) and reconciled such cash for investors and maintained accounts required by the transaction agreements;
- Remittances and reporting: whether the servicer or other relevant party is calculating amounts, allocating and remitting distributions due to investors and reporting such amounts to investors in accordance with the transaction agreements; and
- Pool asset administration: whether the servicer or other relevant party is maintaining the pool assets as required in the transaction agreements.
A registered public accounting firm is required to attest to and report on the responsible party's assertion of compliance with the applicable servicing criteria, and this report will also be filed as an exhibit to the Form 10-K report.
As yet there are no requirements in Canada for any similar reports of compliance with servicing criteria or accountant's attestation of compliance (although this compliance report and attestation are typically required for ABS issuers who file monthly distribution reports and have obtained relief from the requirement to prepare and file financial statements).
Additional Disclosure Items
The SEC Rule stipulates specific events and materials that must be filed on a Form 8-K (roughly equivalent to a material change report in Canada). These include the following:
- bankruptcy or receivership of the sponsor, depositor, servicer, trustee, significant obligor, significant enhancement provider or other material party involved in the transaction;
- the occurrence of an early amortization, performance trigger or other event, including an event of default, that would materially alter the payment priority or distribution of cash flows regarding the ABS or their amortization schedule;
- ABS informational and computational material;
- a change of servicer or trustee;
- a change in credit enhancement or external support;
- failure of the issuer to make any required distribution; and
- a change in the composition of the asset pool by more than 5% from that described in the final prospectus.
Canadian securities laws that require the issuance of a news release and the filing of a material change report when a material change occurs do not differentiate between ABS issuers and other reporting issuers.
E. TIMING AND TRANSITION PERIOD
As a result of the significant changes set out in the SEC Rule, the SEC has granted an extended transition period. Any registered offering of ABS commencing with an initial bona fide offer after December 31, 2005 must comply with the new rules and forms. The SEC provides two transition periods in 2005 for Form S-3 registration statements. For any such offerings relying on Form S-3 registration statements filed after August 31, 2005, such offerings must be pre-effectively or post-effectively amended to make the prospectus included and any required undertakings compliant with these rules. For all Form S-3 registration statements that were filed on or before August 31, 2005, the prospectus and prospectus supplement, taken together, relating to such offerings must comply, provided that the registration statement will need to be posteffectively amended to include any new undertaking in Part II of the registration statement. In addition, after March 31, 2006, all shelf registration statements must be amended prior to any offering to include a compliant prospectus and any newly required undertakings. It is possible for ABS issuers to take advantage of the new rules now (for example, auto lease transactions can now move to a Form S-3), but only if such issuers comply with all the requirements of the SEC Rule.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.